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Year of the Rabbit Delivers a Thumping to the Greenback

The dollar is tumbling this morning as a narrowing in expected growth differentials between the United States and other major economies spurs outward capital flows. After a number of Federal Reserve officials laid out the case for a slower pace of rate hikes and a series of data releases showed softness emerging in American industrial production and consumer consumption levels, investors are piling into bets on the euro, yen, and commodity-exporting emerging markets.

Speculators are net short the dollar on a scale not seen since the middle of 2021 – just before the last historic rally got underway. Make of that what you will.

The euro is trading almost 0.7 percent higher after the European Central Bank’s uber-hawk Klaas Knot said policymakers should deliver half-percentage-point interest rate hikes at the next two meetings, and president Christine Lagarde failed to push back, claiming that policymakers would “stay the course”. Core inflation hit record levels across the euro area in December, and could maintain momentum for months yet, even as price increases in the US show signs of deceleration. The common currency is up almost 2 percent on a year-to-date basis, with market participants largely ignoring lessons learned during the last three cycles – when European rate exceptionalism ultimately proved erroneous.

There are no major economic data releases scheduled for today, and most Asian markets are closed for Lunar New Year celebrations.

A slew of flash purchasing manager indices will arrive through the days ahead, with most economists expecting to see deepening signs of weakness in the global production sector as growth slows and demand for tangible goods retraces toward pre-pandemic levels. Composite and services measures could illustrate surprising pockets of optimism however, with consumers in the United Kingdom and euro area taking a more positive view on inflation and the overall economy than had been feared a few months ago.

The hard data tempo will begin to pick up on Wednesday, when the Bank of Canada delivers what many expect to become its last rate hike in this tightening cycle. After raising rates by four percentage points since last March, the central bank is widely expected to acknowledge signs of slowing momentum in the economy, shifting to a “data dependent” stance in its communications.

A casual observer might assume that this will weaken the Canadian dollar. But a pause has been priced in for months, and the futures curve has long pointed to rate cuts beginning before year end. And if previous rate decisions are any indication, the Bank’s actions could generate a “canary in a coal mine” effect on currency markets globally, foreshadowing dovish tilt from other central bankers in the months ahead.

US gross domestic product numbers for fourth quarter 2022 will land on Thursday, with markets looking for a 2.6-percent year-over-year expansion. Growth is seen slowing from the 3.2 percent pace recorded in the prior quarter as consumer spending, business investment, and residential investment continue to slow. Inventories could represent a wild card, with many businesses struggling to calibrate purchasing activities as easing supply chain issues intersect with increasingly-volatile household spending patterns.

With Federal Reserve officials entering a communications blackout ahead of their January 31-February 1 meeting, market participants will have fewer hawkish speeches to ignore.

But Friday’s personal income and consumption numbers could weaken the case for further monetary tightening. Incomes are believed to have risen 0.2 percent in December as wages kept climbing and tax refunds continued to flow, but spending levels likely fell as energy prices dropped, retailers discounted inventory, and consumers became more cautious. The core personal consumption expenditures index – still understood to be the Fed’s preferred measure of inflation – is seen rising 4.4 percent year-over-year, with the quarterly pace running slightly below the levels set out under the central bank’s last Statement of Economic Projections.

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